Market Memo: The MotM Gold Model

The market is still applying the Fed’s old operating rules when pricing gold. Funds rate hikes in the era of massive excess reserves and a bloated Fed balance sheet offer buying opportunities in gold. The general misconception is that funds rate hikes with massive excess reserves are no different from funds rate hikes before 2008 when excess reserves existed in nominal amounts. In essence the Fed no longer controls the balance between supply and demand for base money. Increases in base money supply flow into excess reserves and base money demand is met by excess reserves. The supply and demand of base money is floating. This is true as long as the Fed maintains its balance sheet at the $4.4 trillion level. The Fed has kept its balance sheet at this level since October 2014. Until the Fed begins to normalize, the Fed does not have direct control of base money supply relative to demand. The relationship between the supply and demand for base money determines the POG. See The Dollar Price of Gold.

The MotM gold model analyzes the POG based on supply-side precepts. Beyond changes in the funds rate, the POG also reacts to geopolitical and fiscal events. Prior to 2008 geopolitical and fiscal events directly affected base money demand. MotM expects similar reactions in the POG to geopolitical and fiscal events going forward as the market adapts to the Fed’s current operating environment. Despite volatility from traditional factors that affect the POG, the bias remains for the POG to rise along with the rising trend in the optimum gold price level. This assumes the Fed’s stated policy of three rate hikes in 2017 and the absence of another financial crisis.

The MotM model estimates the optimum gold price level—today at $1220—and defines the implied value of gold equities relative to the optimum gold price level. The model is currently pricing gold equities at a discount to the optimum level. The discount has decreased with each successive gold decline since July 2015. MotM expects a double win for gold equities at this level. A rise in the price of gold equities to the optimum level and a historical expansion of multiples that will carry prices even higher.